The IRS recently announced the launch of a study to assess the reporting compliance of S-Corporations. S-Corporations are entities that "pass through" their income and deductions to their corporation shareholders. S-Corporations have the liability limitations provided by a regular corporation but are treated, for tax purposes, more like a partnership.

S-Corporations have become one of the fastest-growing tax entities, expanding from 724,749 of them in 1985 to 3,154,377 in 2002. S-Corporations are now the most common corporate entity. But there are a number of restrictions that apply to the formation of S-Corporations. Since the last compliance study involved 10,000 S-Corporations in 1984, the IRS thought it was time to take another peek at them to see whether they are in compliance with the IRS rules and regulations.

You see, since 1984 there have been many changes to the rules regarding the formations and ongoing operations of S-Corporations. The IRS wants to see how many are in compliance with all of the new statutes, restrictions, and requirements that have been put into place over the last two decades. To that end, IRS will examine 5,000 randomly selected S-Corporation returns from tax years 2003 and 2004.

Officials at the IRS expect these audits to begin later this year. Obviously, the IRS will use the information gleaned from these audits to create a program designed to identify S-Corporations that are at significant compliance risk and therefore more subject to future audit.

"This research is critical for achieving our strategic goal of ensuring that corporations and high-income individuals are paying their fair share," says IRS Commissioner Mark W. Everson.

S-Corporations have come under fire lately because of the "beat the FICA tax" aspect to dividend distributions. Unlike partnership distributions, dividends paid by S-Corporations are not subject to either FICA taxes or self-employment taxes (which are nothing more than FICA taxes for the self-employed). Many taxpayers are setting up S-Corporations, are acting as employees of the corporation, but are not paying wages to themselves. Instead, they simply take the profits out of the S-Corporation in the form of dividend distributions. They have effectively busted the system, since they have avoided both FICA and Medicare taxes on those dividend distributions. If they were to compensate themselves for the work performed via W-2 wages, both the employee and employer would be paying FICA and Medicare taxes. The IRS has already set up a task force to review various S-Corporations indicating no wages paid to corporate officers or directors.

Depending on whom you believe, the Social Security System will be virtually broke sometime between 2015 and 2042. That being the case, it's imperative to generate as many Social Security dollars as possible now, while the system is still viable. And while FICA and Medicare taxes aren't income taxes per se, the IRS is still in charge of making sure that S-Corporations are in compliance with the wages that should be paid.

IRS has already identified the so-called "tax gap"-- the difference between what taxpayers are actually paying and what they should be paying -- and has addressed that issue in a recent release. The S-Corporation audits are just a small piece of the overall enforcement pie. Going forward, you can expect to see additional enforcement and compliance studies and actions undertaken by the IRS. The President has called for a nearly 8% increase for enforcement activities in the administration's 2006 IRS budget request. The additional funding will increase audits of corporations and high-income individuals as well as expand collection and criminal investigation efforts.

So beware ... the tax man cometh.

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